Low Volatility ‘Can Last For a Very Long Time’: Barclays

By Brendan Conway

If you plot the history of the CBOE Volatility Index, a few things jump out. One is the deep trough from 2002 through 2007. That was roughly five years of relative calm in the market, at least by this measure.

You also see a large spike during the financial crisis, followed by a few years of aftershocks.

Barclays Capital’s Michael Gavin has his eye on the calm period between 2002 and 2007. Here’s what the strategist wrote to clients this week:

After the searing experiences that have been visited upon investors since the 2008 credit crisis, ‘vicious circle’ dynamics have become an all-too-familiar element of the economic and financial landscape. Investors have learned that a decline in home prices may impair the financial system’s ability to extend credit, leading to yet weaker home prices and a vicious circle that could, in the absence of official intervention, undermine the entire system. Sovereign creditors may seem creditworthy, until a confidence shock raises funding rates, which reinforces initial doubts, until an official rescue may be necessary. Jittery investors may respond to asset price declines by hiding in safe havens, thus intensifying the sell-off of risky assets, at least until valuations become compelling enough to drag investors back.

With this sort of dynamic in mind, many have become suspicious of periods of low volatility because, during the post-crisis period, they have so often proved to be the calm before a storm, serving mainly to promote over-extended positioning that sets the market up for its next fall. But not all economic and financial dynamics are unstable, and if recent history teaches that periods of low volatility often give way to a bout of market instability, the 2002-07 ‘inter-crisis’ period teaches us that periods of very low volatility can last for a very long time.

In the present context, the most obvious and important stabilizing dynamic lies in the highly activist policies of the systemically important central banks. We do not think we need to remind investors how this financial ‘safety blanket’ dampens market sensitivity to bad economic or political news. One day, this actual and contingent activism will have to be tempered by concern about inflation and/or financial-market ‘froth’. But that day is not imminent.

With respect to equity markets, in particular, we suspect that growing doubts about the sustainability of low safe haven (and near safe haven) bond yields has become a complementary stabilizing factor. With bond yields still near historical lows, and below dividend yields on the main equity indexes in the US, UK, eurozone and Japan, it seems to us that bondholders are becoming increasingly edgy about medium-term downside market risks to their bond positions from a normalization of global monetary conditions, however gradual this is likely to be. This is one more thing to think about that may contribute to investors’ willingness to hold equity risk through a bad headline or two.

Of course, this whole context could change if some risk materializes that cannot be contained by activist central banks. But the main risks that have preoccupied investors in the past several years seem unlikely to return to such menacing proportions, and new ones that will some day face investors seem unlikely to emerge for some considerable time to come. We think it makes more sense for investors to focus on navigating a generally low-volatility environment than to prepare for another outbreak of anxiety in the months to come.

Barclays iPath S&P 500 Short-term VIX Futures ETN (VXX) is down 1.1% and ProShares Ultra VIX Short-Term Futures ETF (UVXY) is down 2% with a few minutes left in Wednesday’s session.

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